I am a Tax Partner in WithumSmith+Brown’s National Tax Service Group and the founding father of the firm's Aspen, Colorado office. I am a CPA licensed in Colorado and New Jersey, and hold a Masters in Taxation from the University of Denver. My specialty is corporate and partnership taxation, with an emphasis on complex mergers and acquisitions structuring. In the past year, I co-authored CCH's "CCH Expert Treatise Library: Corporations Filing Consolidated Returns," was awarded the Tax Adviser's "Best Article Award" for a piece titled "S Corporation Shareholder Compensation: How Much is Enough?" and was named to the CPA Practice Advisor's "40 Under 40."

In my free time, I enjoy driving around in a van with my dog Maci, solving mysteries. I have been known to finish the New York Times Sunday crossword puzzle in less than 7 minutes, only to go back and do it again using only synonyms. I invented wool, but am so modest I allow sheep to take the credit. Dabbling in the culinary arts, I have won every Chili Cook-Off I ever entered, and several I haven’t. Lastly, and perhaps most notably, I once sang the national anthem at a World Series baseball game, though I was not in the vicinity of the microphone at the time.

Tax Geek Tuesday: Tackling The Dreaded Section 754 Adjustment

This increase in inside basis would then be depreciated by the partnership based on the useful life of the underlying property. Because the $100,000 increase in depreciable basis is specific to X, however, any depreciation deductions generated by the basis increase would be allocated specifically to X.

Making the Election

The Section 754 election must be made before the due date of the income tax return (including extensions) for the year in which the transfer occurs. The partnership makes the Section 754 election by attaching the appropriate information to its income tax return. Once the election is made, it applies to all future transfers unless the election is revoked.

The election can be revoked only with permission from the IRS. A partnership wishing to revoke the election should file a request within 30 days after the close of the partnership year for which the revocation is intended to take effect. The request should state the reason for the revocation. Regulations list the following as acceptable reasons: (1) change in the nature of the partnership’s business, (2) substantial increase in partnership assets, (3) change in the character of partnership assets, and (4) increased frequency of retirements or shifts of partnership interests increasing the administrative burdens of the election.

Should You Make the Election?

As this discussion (hopefully) illustrated, whether a partnership makes a Section 754 election should not change the net tax effect of a transaction on a partnership or its partners. It should, however, put the buyer of a partnership interest in the advantageous position of not having to wait until a partnership liquidates to be made whole.

As a general rule, if a partnership has assets that are steadily appreciating (i.e., real estate partnerships) and routinely experiences changes in partnership interests, a Section 754 election should be given strong consideration. But are there any downsides?

Of course there are. As indicated above, once the partnership makes a Section 754 election, it’s stuck with it. This means that if property loses value, a partner who buys an interest for less than the selling partner’s share of the inside basis of the property must decrease his share of the inside basis of the partnership property.

To illustrate, assume the land held by Partnership ABCD lost value from $800,000 to $400,000, the other asset retained a basis and value of $200,000, and X bought A’s interest for $150,000 (25% of the total value of $600,000). If a Section 754 election were in place, the partnership would be required to reduce the tax basis of its land – specific to X – by the excess of X’s share of the inside basis of the assets ($250,000) over X’s outside basis in the partnership interest, or ($150,000.) As a result, the partnership would actually decrease its basis in the land by $100,000, specific to X.

Making matters worse, if the land were depreciable property, the depreciation on the resulting $100,000 decrease in inside basis would give rise to a rather anomalous result: negative depreciation deductions, or stated in another way, depreciation deductions that increase the income of X.

Lastly, and from a purely selfish perspective, tax advisors should consider what a colossal pain in the ass maintaining and managing Section 743 and 734 increases or decreases – and the resulting depreciation – can be. These are not simple concepts, and we didn’t even broach the rules for allocating between multiple classes of assets under Section 755 or dealing with tiered partnerships. Add these complexities up, and the reality is that managing a client with Section 754 adjustments requires a lot of man hours, and it can often be very difficult to receive equal value from the clients in the form of billings.

Obviously, whether to make a Section 754 election ultimately comes down to the specific facts of your client. But hopefully this discussion shed some light on why you might want to consider making an election, and how it works once you do.

Got an idea for a Tax Geek Tuesday? Send it along to anitti@withum.com or on twitter @nittigrittytax

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Comments

Thanks for this fantastic and in depth article. Your timing is serendipitous, as I have been trying to find something exactly like this for weeks to no avail. Your bosses should know that you just won them a lifetime subscription to Forbes magazine from this very grateful reader.

Great article Tony. You may want to keep the example going and expand in next article to cover in-kind distributions. Also, note that there are mandatory basis adjustments even absent a 754 election where there is a substantial basis reduction – often overlooked.